Home Equity Loans and Home Equity Lines of Credit
In simplest terms, "equity" is the difference between what your house is worth (its appraised value) and how much you currently owe on the property (your loan amount). So, for example, if your home has an appraised value of $400,000 and your loan amount is $300,000, then you have $100,000 in equity ($400,000 minus $300,000). Stated another way, your loan to value is 75% (loan $300,000 divided by value $400,000), and your equity is 25% of the value of the home (100% minus 75% or $100,000 divided by $400,000).
Therefore, if you need $40,000 for home improvements, or to pay off credit card debt, you could borrower $40,000 from a lender by using your home as collateral - "by tapping into your home equity". Based on the example above, the total amount of money borrowed and secured by your home is now $340,000 ($300,000 old debt plus $40,000 new debt). The appraised value of the home is $400,000. So, your new loan to value is 85% ($340,000 loans divided by $400,000 value). In other words, by borrowing an additional $40,000 against your house, you have reduced your equity from 25% to 15% (25% -10% = 15%).
Both Home Equity Loans and Home Equity Lines of Credit (also referred to as HELOCs) are available to homeowners that have "equity" in their homes. The primary difference between a Home Equity Loan and a Home Equity Line of Credit (HELOC) is that a HELOC works much like a credit card or checking account. A HELOC allows you to obtain cash when you need and to pay interest only on the outstanding balance. A Home Equity Loan, on the other hand, is a second mortgage loan that works much like your first mortgage. Your loan proceeds come to you in one lump sum.
Home Equity Loans usually have fixed interest rates and fixed payment amounts for usually 10 to 15 years. Most HELOCs work off adjustable-rates, so if the interest rate goes up, so does your monthly payment.
KEEP IN MIND: Since these equity loans are riskier than first mortgages (lenders with first mortgages are in a better position to get their money back in a default situation), Home Equity lenders charge higher interest rates. Also, you will have closing costs, such as the processing and appraisal fees.
FINALLY CONSIDER: Interest charged for student loans, credit card debt, and car loans is classified as consumer interest. The law says you can't use consumer interest to reduce your state and federal income tax liabilities. Mortgage interest, on the other hand, is generally tax deductible. On a Home Equity Loan and Home Equity Line of Credit you may be deduct the interest you pay for both federal and state income tax purposes. However, there is a limit on the tax deductibility. In 2001, the limit is $100,000 of interest paid. Any interest you pay in excess of the $100,000 limit is considered consumer interest, and therefore not tax deductible.